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Time to revisit the idea of public sector banks

LiveMint 02-05-2017Livemint

In his July 2009 budget speech, Pranab Mukherjee had claimed that government ownership of the financial system was the main reason why the Indian economy had managed to stay on an even keel despite the turbulence around the world after the collapse of investment bank Lehman Brothers a few months earlier. “Never before has Indira Gandhi’s bold decision to nationalize our banking system exactly 40 years ago—on 14 July 1969—appeared as wise and visionary as it has over the past few months. Her approach continues to be our inspiration even as we introduce competition and new technology in this sector,” the then finance minister had claimed.

Mukherjee was echoing a view that was common then. The dominance of public sector banks was supposed to have lent the Indian financial sector unique stability in an unstable world. All this is now worth remembering at a time when the state of the Indian banking sector—still predominantly owned by the government—is the single biggest risk to economic stability.

Even as the Indian central bank and the finance ministry struggle to deal with the stock of bad debts that has clogged the banking system, it is worth kicking off a debate about what needs to be done to avoid a repeat of the current mess. Here are three suggestions.

Also Read: It’s time to privatize banks

First, government ownership of the Indian banking sector needs to be drastically reduced. Reserve Bank of India (RBI) deputy governor Viral Acharya boldly asked in a speech last week whether Indian banks need to be privatized. His excellent speech deserves to be read in full for its other suggestions on how the banking mess can be dealt with. Bank privatization is a worthwhile project for the Narendra Modi government to follow. The starting point should be reviving the proposal tabled in Parliament by the Atal Bihari Vajpayee government to bring down government holding in public sector banks to 33%.

Second, allow new private sector banks to bloom. Privatization of public sector banks will necessarily be a slow process. It requires legislative change. Investor interest in many of the weaker banks will most likely be absent. And most public sector banks trade at discounts to book value, so the government will in all probability come under attack for selling at low prices. The government should thus shift its attention away from the current enthusiasm for public sector bank consolidation to promoting bank competition through the creation of new private banks. Such privatization by stealth needs to be promoted even as the bigger battle for public sector bank privatization is fought.

Third, India needs a more diverse financial system so that banks are not burdened with tasks they are not suited for. The current mountain of bad debts can at least partly be explained by the pressure from New Delhi during the tenure of the previous government to fund large infrastructure projects as well as generally push lending at a rate that was far faster than the underlying growth in nominal gross domestic product. The result was a credit bubble that later popped. The Modi government needs to back the RBI in its quest to build a diverse financial system through the growth of finance companies, specialized infrastructure lenders and the corporate bond market. The recent shift in corporate lending patterns—especially the growing importance of non-bank sources of funds—needs to be further encouraged.

Also Read: Will RBI walk the talk on bank consolidation?

All this needs to be supported by a robust regulatory regime that can identify problems as they emerge rather than when they can no longer be hidden from view. The Indian central bank deserves credit for forcing banks to come clean in the asset quality reviews, but it also deserves criticism for not being able to spot the problem earlier.

Bank nationalization did have its historical role, especially the financial deepening in the 1970s as a result of the expansion of the branch network. The result was higher savings that created the conditions for the acceleration of economic growth after 1980. But the damage done was also immense. Lending directed by the state rather than business calculations has meant that Indian banks have slipped into crisis mode at the end of every business cycle.

Mukherjee passionately defended bank nationalization on the 40th anniversary of the controversial event. We hope Arun Jaitley turns the tables when the 50th anniversary is due in 2019. He should stand up in Parliament to announce that he has undone the bank nationalization of 1969.

Will the Narendra Modi government move on the privatization of public sector banks? Tell us at views@livemint.com